1.8.1 Agency Theory
Much of the research about corporate governance has been derived from Agency Theory. Principal-agent problems arise from the dispersed ownership in the organizational structure of modern corporations. Corporate Governance has been regarded as a mechanism by which Board of Directors (BOD) undertake crucial monitoring to minimize the problems arising from the principal-agent relationship. As per this theory, managers are agents and the owners and BOD acting as the monitoring mechanism are regarded as the principal.
The role of BOD in governance includes serving the shareholders by ratifying the decisions taken by the managers and monitoring the implementation of such decisions. The separation of ownership from management can entice managers to take action that may not be in the best interests of the shareholder’s wealth. In order to prevent the managers from misusing their firm specific knowledge and expertise to benefit them and not the owners, a monitoring mechanism is deliberated to protect the shareholder interest.
Here, accounting plays a vital role in reducing the agency costs (monitoring costs and disciplining the agent to prevent abuse) in an organization, effectively via written contracts tied to the accounting systems. It represents a crucial component of corporate governance structures, as if a manager’s reward is based on factors like accounting profits, efforts would be made to deliberately fudge increased profits leading to an increase in bonus or remuneration just by the selection of a particular accounting policy that will increase profits. Arising from the above is the agency problem on how to induce the agent to act in the best interests of the principal.
Assumptions of the Agency Theory are:
- Individuals have access to complete information
- Investors possess significant knowledge of whether or not governance activities conform to their preferences
- Board has knowledge of investors’ preferences
Therefore, as per the agency theorists’s view, an efficient market for corporate control, management labor and corporate information is regarded as a solution to reduce the agency problem.